Bolstered by a litany of stronger-than-expected economic data, Wall Street continued its trek higher last week, and the major market indices logged their fourth consecutive positive week in the first week of June. By the end of the week, however, worries emerged that the improving economic environment might raise the specter of inflation, making for a rough finish to an otherwise positive week of trading. Looking at the week ahead, Todd Salamone, Senior Vice President of Research, examines the potential for a breakout by the S&P 500 Index (SPX), which has been patterning its performance after the start of 2008. Furthermore, Todd examines the difficulty in reading sentiment when the market is in a transitional period. Then, Senior Quantitative Analyst Rocky White examines the gamma-weighted Schaeffer's put/call open interest ratio (SOIR), the indicator's recent decline, and the potential impact on the SPX. We wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: Bulls Cling to Momentum as Economic Data Spark Inflationary Concerns By Joseph Hargett, Senior Equities Analyst
June entered with a bang last week, as the bulls clung to momentum gained from three straight months of gains and a steadily improving string of economic reports. On Monday, spring fever swept the Street, as the Dow Jones Industrial Average (DJIA) skyrocketed to a gain of 2.6%, despite General Motors' (GMGMQ) bankruptcy filing. Boosting sentiment were stronger-than-expected reports on personal income, construction spending, and an unexpected rise in the Institute for Supply Management's (ISM) manufacturing index. On Tuesday, investors weighed encouraging housing data against a sell-off in the financial sector, but the Dow managed to swing to a gain of 0.22% by the close. Early in the session, the National Association of Realtors reported that existing home sales rose 6.7% in April, marking the third straight monthly increase. However, selling pressure escalated on financial stocks after a bevy of banks, including American Express Inc. (AXP) and JPMorgan Chase & Co. (JPM), announced plans to offer common stock in order to repay Troubled Asset Relief Program (TARP) funds.
A weaker-than-expected employment report from ADP spooked traders on Wednesday, sending the DJIA down for a loss of 0.75%. Though the number of slashed salaries was the fewest since November, the figures were worse than analysts expected. Adding fuel to the fire was Federal Reserve Chairman Ben Bernanke, who told the House Budge Committee that, "Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth." The atmosphere on Thursday was tense, as investors awaited Friday's May nonfarm payrolls data, but the Dow still managed a gain of 0.86%. Mixed same-store sales data from the retail sector contributed to shaky trading in the morning, but economic data offered up better-than-expected weekly initial jobless claims, and Goldman Sachs boosted its 2009 price target for crude oil, ushering the energy sector to the top of the heap.
Stocks endured a volatile session on Friday, with Wall Street sending mixed messages in the wake of the May nonfarm payrolls report from the Labor Department. Specifically, the U.S. economy shed a smaller-than-expected 345,000 jobs during the month, while the unemployment rate surged to 9.4%, outpacing analysts' expectations. Meanwhile, inflationary concerns jumped to the forefront as the U.S. dollar raced higher against a few key foreign rivals, prompting investors to worry that the Federal Reserve might be forced to raise interest rates before a full economic recovery can take place. The Dow finally settled on a gain of 0.15% for the day, setting the blue-chip barometer's weekly rally at roughly 3%. Elsewhere, the S&P 500 Index (SPX) added 2.3% for the week, while the Nasdaq Composite (COMP) rose 4.2% on a week-over-week basis.
What the Trader Is Expecting in the Coming Week: Can the S&P 500 Index Break the 2008 Pattern? By Todd Salamone, Senior Vice President of Research
Is the stock market finally breaking the pattern of 2008? The first week of trading in June suggests that the odds are growing for a divergence from last year's blueprint. Last week, for example, I discussed the S&P 500 Index's (SPX) trading-range environments in May 2008 and May 2009, which both followed strong rallies from lows set in March. In 2008, however, the SPX was not able to move back above its 200-day moving average, as the May trading range resolved with a tumultuous drop in June 2008. In contrast, June 2009 has begun on a positive note, with the SPX breaking above its 200-day moving average last week for the first time since December 2007.
We have researched the SPX's historical performance to catch a glimpse on how the index has behaved once it closes above its 200-day moving average, after trading below this trendline for a lengthy period (defined as 90 consecutive days or more). The table below summarizes the results of these occurrences, which took place 10 times since 1972. For the six-month and 12-month periods following these signals, the SPX shows slight outperformance relative to its at-any-time returns. However, there is a lot of volatility, as expressed by the median returns following the signal. There is actually underperformance during the first three months after the signal, which is interesting as we embark upon a period of weak seasonality.
The SPX's 200-day moving average is a popular theme among technicians in terms of a risk to the bullish case. Such concerns could have very well set the stage for the breakout, as they represented sideline money that could ultimately push the index higher. A question we have raised internally is, "Will the breakout become a 'false breakout' as the last of potential buyers finally capitulate?" This is certainly something to be open to, as the SPX struggles to sustain a convincing move above its January 2009 high of 943.85.
Should this resistance finally cave, we could easily see a rally up to 1,000 on the SPX. The 1,000 level is not only important from a round-number perspective, but it would represent a 50% advance from the index's March low of 666.79. Plus, it is the area of the SPX's declining 52-week moving average. Should the market decline in the near future, an area of potential support is 920, which is the current site of the SPX's 200-day trendline.
One difficulty in handicapping the current market environment is in the interpretation of sentiment data during periods of transition from bear to bull environment. For example, the 10-day moving average of the International Securities Exchange (ISE) all-equity call/put ratio, the American Association of Individual Investors (AAII), and Investor's Intelligence weekly sentiment surveys are at levels that have marked peaks during rallies within the bear market. While these indicators are at levels that suggested too much optimism during bearish long-term trends in the market, they are far from the levels that define optimism during bull market periods. In other words, it takes higher levels of optimism during bull market trends to generate "sell" signals relative to bear market periods. As long as the SPX trades above its 200-day moving average, be open to the possibility that there is room for optimism in these indicators to grow further, which in turn would be a tailwind for the stock market.
One thing that we have found interesting, but I haven't discussed much in this space, is the behavior of the buy (to open) put/call volume ratio on the SPX. The graph below highlights the 50-day moving average of this buy (to open) put/call activity. Our theory is that professionals use SPX put options as a tool to hedge long exposure. Therefore, as buy (to open) put activity increases relative to buy (to open) call activity on the SPX, the long trade gets more and more crowded. Note that this ratio peaked at about the same time that the SPX peaked in late 2007. What's more, the steady decline in the ratio was concurrent with the market's struggles, as professionals de-leveraged.
As I mentioned on CNBC last week, the fact that this ratio is turning higher from its recent lows is a sign of the de-leveraging process ending, as professionals steadily increase their long exposure. We will continue to monitor this indicator. A turn lower in the ratio would likely have bearish implications, while a continued advance in the ratio would have bullish implications.
Last week, I mentioned Treasurys as a potential long trade, given the extreme in pessimism that we've observed. This week, I'll add the U.S. dollar as a potential long play, as we are seeing negativity reach multi-year extremes according to at least one sentiment survey that we follow. In addition, the U.S. Dollar Index is currently trading at potential long-term technical support. One way to play unwinding negativity on the U.S. dollar is through the ISE FX Australian Dollar Index (AUX), which measures the relationship of the U.S. dollar versus the Australian dollar. Since gold could be setting up for another failure near $1,000, amidst bullish anecdotal sentiment of the "any economic scenario is bullish for gold" variety, a bullish play on the U.S. dollar versus the Aussie could make the most sense. AUX calls, for example, would seem to be a play related most to dollar strength and gold weakness (carry trade currency).
Indicator of the Week: Gamma-Weighted Schaeffer's Put/Call Open Interest Ratio (SOIR) By Rocky White, Senior Quantitative Analyst
Foreword: One of the better known indicators here at Schaeffer's is the Schaeffer's put/call open interest ratio (SOIR). The SOIR tracks put and call open interest for the front three expiration months. Similar to that, we also track a gamma-weighted SOIR in which we weigh open interest according to the option's gamma. I am discussing the gamma-weighted SOIR this week because it has made a very sizable move recently. Below, I take some time to explain this ratio and delve into what the current reading might mean for the market.
What is Gamma?: Since this is not meant to be an article on option Greeks, I will only briefly describe gamma and its relevance to the SOIR. The Greeks are used to quantify how sensitive an option is to certain variables. Delta and gamma are relevant for this article (other Greeks include vega, theta, and rho). Delta describes how sensitive the option price is to changes in the underlying asset's price. Gamma, meanwhile, tells an option trader how much the delta will change with respect to a change in the underlying asset's price.
To understand why we use gamma, you only need to look at the chart below, which shows an option's gamma depending on its strike price. An option that is at-the-money (ATM) has a very high gamma. The farther the strike price is from the stock price, the smaller the gamma. For the gamma-weighted SOIR, we multiply the option's gamma by its put and call open interest, separately. Dividing the gamma-weighted puts by the gamma-weighted calls gives us the gamma-weighted SOIR. Doing this creates a SOIR that gives higher importance to open interest that is near the money, while almost disregarding open interest that is either deep in the money or deep out of the money.
Why Are At-The-Money Options Relevant?: Why focus on ATM open interest? We are quantifying this data in order to determine the sentiment of a stock (or the market) and predict the price action. In the event of a violent market decline, ATM put options will suddenly become very profitable. Quite a few option players will close these open positions to book profits. Therefore, that put open interest disappears. However, call options will decline in value quickly if the market declines sharply, and may basically become worthless. There is no market for these worthless calls, so they just sit on the books waiting to expire. This inflates the amount of call open interest when you look at the number of puts compared to calls. What's more, it skews the sentiment readings, because that open interest is not there because a trader is bullish on the stock, it's there because the trader simply cannot sell it.
Also, large accumulations of open interest near a stock price can change the dynamics of a stock's price action. Huge call open interest just above a stock price can act as resistance and heavy amounts of put open interest below a stock may act as support. This is especially true during expiration week, as hedges related to these options are unwound when they are no longer needed, thus applying pressure to the security.
Analysis: Let's look at a graph of the 21-day moving average for the gamma-weighted SOIR alongside the S&P 500 Index (SPX). As you can see, the gamma-weighted SOIR has fallen off a cliff recently, dropping to its lowest level since the summer of 2007 -- just before the market collapsed. This extremely low reading is telling us there are a larger number of ATM call options relative to put options.
Implications: Scanning the chart above, you see that prior peaks in the gamma-weighted SOIR seem to coincide with short-term market lows. Meanwhile, troughs in this ratio seem to coincide with short-term highs. As such, the recent drop-off in this indicator does not bode well for the market. Specifically, as I noted above, the buildup of ATM call open interest may act as resistance for stocks trying to head higher. I don't mean to be a downer in the midst of a market rally, but this indicator is signaling caution, and will grow increasingly more relevant as we near expiration week.
This Week's Key Events: Trade Balance and Consumer Sentiment Data on Tap By Joseph Hargett, Senior Equities Analyst
Here is a brief list of some of the key events for the upcoming week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective Web site for official reporting dates.
Monday
The economic calendar is devoid of reports on Monday. On the earnings front, FuelCell Energy Inc. (FCEL) and Pall Corp. (PLL) are slated to release their quarterly reports.
Tuesday
Only April wholesale inventories data is scheduled for release on Tuesday. Elsewhere, The Pep Boys (PBY), The Talbots Inc. (TLB), Shuffle Master Inc. (SHFL), and Sina Corp. (SINA) are among those reporting earnings.
Wednesday
On Wednesday, the Street will be graced with April's trade balance, May's Treasury budget, the weekly report on U.S. petroleum stockpiles, and the Fed's Beige Book. Meanwhile, The Men's Wearhouse, Inc. (MW) is scheduled to report earnings.
Thursday
May's retail sales, April's business inventories, and weekly initial jobless claims are among Thursday's economic releases. The earnings calendar includes Del Monte Foods Company (DLM), HOKU Scientific Inc. (HOKU), Lululemon Athletica inc. (LULU), and National Semiconductor Corp. (NSM).
Friday
Friday rounds out the week with May's import/export prices and the preliminary University of Michigan consumer sentiment index for June. There are no major earnings reports scheduled for release.
Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insights about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.
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